Avoiding US stocks to increase expected returns

[nomadscientist]

Please pretend I posted this before the COVID crash because it will make more sense (although the difference today is still more quantitative than qualitative).

I've heard people say that you should save more now than in for example 2009 to retire with a given income because the high price to earnings ratio of US stocks implies depressed future returns. This isn't true of all developed markets though. Why shouldn't you just put all your equity allocation in, say, the UK FTSE 100 index? This index had a price/equity ratio of ~15 before COVID and is based in a country with similar age and stability of free market institutions to the USA.

Of course the market as a whole cannot do this because if every 401k in America suddenly switched from VTSAX to VUKE they would simply buy the whole FTSE 100 multiple times over (read: increase the price). But an individual with $300k to invest sure can do so without any appreciable effect on the price of the index.

Work 50% longer to retire early, or ditch home team bias? What am I missing?

[classical_Liberal]

Think in terms of a value trap. I'm not saying all of developed Europe is, just that I think it potentially could be given their markets, economic systems, etc vs other developed and developing countries. IOW, They have competitive disadvantages globally, and locally have cultural, economic, and demographic issues that may impede future growth.

https://www.investopedia.com/terms/v/valuetrap.asp

[nomadscientist]

The argument for US stocks being overvalued assumes equities mean revert in P/E and differences from the mean don't reflect long term value differences. Is this argument wrong? Why?

[sky]

You also have risks of currency fluctuations.

[nomadscientist]

You also have risks of currency fluctuations.

True. So let's add a USD hedge.

[classical_Liberal]

The argument for US stocks being overvalued assumes equities mean revert in P/E and differences from the mean don't reflect long term value differences. Is this argument wrong? Why?

Specifically, are you talking PE or CAPE? or another PE metric? If you are talking about mean CAPE, I think there are good arguments about why mean CAPE changes over time/the life-cycle of an economy. Developing vs Developed, etc. There are also aspects of penetration of one country's economy into anothers. Are there global markets still available for a particular economy to use for growth? Are they competitive vs other global economies in those regions of growth? If not, locally, is there still growth available? Stagnated growth will reflect in lower PE's. This does not mean it is a value compared to an economy who is still seeing substantial growth in it's markets. Then there's systemic economic risk as well. So an economy with sustained growth, with limited overall risk of capital (ie less worry the country's economy will totally collapse or nationalize companies) will naturally have higher PE's.

IOW, the UK has a different economy than it did in 1920, so does the US, so does China. Comparing mean PE's in 1920 to today are not really comparing apples to apples, even though the metric hasn't changed, circumstances within the economy have. Long term mean reversion is not a given. Many have argued QE and low yielding Treasuries alone have fundamentally changed the financial markets enough to alter mean CAPE, due to asset inflation. This is only the most recent change over the past century.

[nomadscientist]

How do you determine how much money you need to retire? You seem to reject use of historical data.

[classical_Liberal]

I semi-retired instead, in part because i do not trust my historical modeling. I don't think FI alone is robust enough for me to feel safe.

I use Tyler9000-esque non-correlated assets as an investing strategy. Also, I'm in the US and do hold international equities. Not because I believe they are a better value though, I'm just using poor mans risk reduction through diversification of economies and currencies.

[nomadscientist]

I semi-retired instead, in part because i do not trust my historical modeling. I don't think FI alone is robust enough for me to feel safe.

I use Tyler9000-esque non-correlated assets as an investing strategy. Also, I'm in the US and do hold international equities. Not because I believe they are a better value though, I'm just using poor mans risk reduction through diversification of economies and currencies.

You're saying the premise:

"I've heard people say that you should save more now than in for example 2009 to retire with a given income because the high price to earnings ratio of US stocks implies depressed future returns."

is wrong.

OK, maybe.

Historically it's been right though. What do you think of my proposed remedy, if the premise is right?

[classical_Liberal]

"I've heard people say that you should save more now than in for example 2009 to retire with a given income because the high price to earnings ratio of US stocks implies depressed future returns."
is wrong.

No

I'm saying that a return to historical mean CAPE may not be realistic. 2009 is evidence of this as CAPE only remained below historical mean for a short period of time. Future returns may very well be diminished if the current economy mean CAPE is higher than total historical. So you may need to save more as returns will be lower, but to expect pricing to return to below long term historical mean CAPE (in US market) for any significant period of time may not be realistic in today's macroeconomic world.

I'm also saying that the lower CAPE in Developed Europe is reflective of a different economic environment. Low growth, lack of international competitiveness in high growth markets being two of my suspicions. This is akin to a value trap. I do not expect Developed Europe to outperform the US despite the differential in CAPE due to macroeconomic differences. I do buy some of these indices though, purely as diversification away from my home countries currency and policies. I do anticipate in a "good" future scenerio they will underperform.

[nomadscientist]

You believe that US stocks are fairly priced because 23 (or 30) CAPE 10 is the new normal, while European stocks are unfairly priced because they're too expensive because European trend CAPE 10 in the future will be like 7 or something.

I am asking on the assumption that all developed free market country stock markets have a long run trend of 15 or so.

[Seppia]

The UK is just one tiny country. I would not be willing to hitch my wagon to it 100%.
I do think though that ex-US has a higher probability of performing better than the USA market in the next 10-15 years.
These things go in cycles and the USA are coming out of a spectacularly over performing decade.

In the late nineties Europe performed much better than the USA market. The narrative was that with the euro coming, it would have challenged the dollar as the world reserve currency and would have created an alternative superpower to the USA, whom would certainly face decline.
Now the view is that the USA economic system, lower taxation and tech dominance will allow it to rule the world forever and Europe with its cumbersome regulation and all this stupid fascination with reducing emissions is doomed.
we shall see.
For example, I would expect european safety nets to be able to absorb the pain coming from COVID19 business destruction better.

[IlliniDave]

Fwiw, I try to keep things diversified. Typically there are reasons that investors will pay more for a dollar of earnings in one stock or market versus another. Sometimes the reason is irrational, sometimes it's not. Often it is a matter of perceived risk. I've held overseas equities for a long time, and only for the period mentioned by Seppia have they outperformed for a dollar-denominated investor. I don't know why that is. We might be on the cusp of another such period, or might have been before c-19

I don't know why CAPE or PE is higher in the US.I don't know how comparable PE is as a metric across international borders. But I assume it is at least marginally significant, so I keep investing in developed and developing ex-US markets. But I have not stopped investing in US equities. However, while I was ratcheting down my stock allocation from 2017 to February of this year, it was US equities that I sold. When the recent fall unbalanced my allocation and I started buying equities again, I've been buying both. So in the net I shifted slightly away from US equities without abandoning them.

I think the main thing I would consider before going all-in on a low PE market is why is it a low PE market? Tax laws? Lack of investor protections? Peculiar risks to that market/country? Demographics? Composition of the economy? If I had a good understanding of the factors that caused the low PE and decided the risk was within my tolerance, then maybe I'd consider it.

[classical_Liberal]

I am asking on the assumption that all developed free market country stock markets have a long run trend of 15 or so.

Given the option of investing in the US at CAPE 25 or developed Europe at CAPE 15, I think the US will outperform at those pricing levels. I used to think like @seppia, and was increasing my international holdings, now I'm less sure and have relegated them to poor mans risk control (ie diversification outside of my home country's potential problems).

You are free to disagree. My opinion is that developed Europe will mostly be a net zero growth zone. Whereas I believe the US is positioned particularly well to achieve growth in the service sector inside its borders, and in personal tech arena in the new growth regions in Asia, India, and potentially Africa in the next couple of decades.

[Bankai]

Europe was a low growth zone for a long time. There are many reasons for that, but I expect the UK will outperform the other 3 big European countries over the next 10-20 years. Some reasons being: relatively healthy demographics structure & growing population (similar to France and better than Germany & Italy), less regulation, much less developed (thus less costly) safety net, 75% of FTSE100 earnings are made abroad. If you assume profits will go back to pre-COVID levels, at current market valuation we're looking at 6% dividend yield; with a further 2% coming from economic growth for 8% total annual return going forward. And that's before P/E expansion; if you include it 10% pa is not impssible.

[jacob]

I've heard people say that you should save more now than in for example 2009 to retire with a given income because the high price to earnings ratio of US stocks implies depressed future returns. This isn't true of all developed markets though. Why shouldn't you just put all your equity allocation in, say, the UK FTSE 100 index? This index had a price/equity ratio of ~15 before COVID and is based in a country with similar age and stability of free market institutions to the USA.

You're looking for an argument like this: https://www.gurufocus.com/global-market ... ountry=AUS (see sidebar, see the USA for an explanation).

Overall, the idea is that GDP change+Dividend yield+Currency change+Multiple change => return on investment.

The least predictable ones are the currency change and the multiple change. The currency change is easily "fixed" with a currency-hedged ETF. For example, the currency-hedged version of EWA is HAUD. In the long run a strong economy => strong currency (at least in relative terms). However, in the short run, you'll often see a rising stock market compensated for by a falling currency. (People sell the currency to buy the stocks, so it evens out.)

The bigger issue is the multiple expansion. Is it mean reverting or trending? If you look at all the countries, you'll see that they have wildly different numbers. The average TotalMarketCAP/GDP for the US is 80%, but until COVID, it had risen to 150%+ (It is currently about 110%, moderately overvalued in historical terms.) Conversely, the average over the last decade for Italy is about 10% whereas the average for Switzerland is 250%. Clearly, there's no "physics-based" right TMC/GDP number in between countries. Much of this will depend on tax laws, economic growth rates, etc.

The $1M question is whether historical means within the country hold. They're certainly subject to the same changes as between countries. For example, if the tax laws change in 2025 to disfavor equity, the multiple will diminish. A slowing productivity growth will also ultimately cause it to go down. Productivity has actually been declining in the US for decades but TMC/GDP is up. In particular, it looks like TMC/GDP has been boosting stock market returns since about 1983. This has led to many anecdotally confirmed stories about how the stock market always goes up even in the medium-run... just wait and it'll trend up again in 2-3 years, says everybody until the age of 65. so what gives? Is this just a Greater Fool play?

P/Es are mainly influenced by growth rates and inflation rates. You can see the growth rate in the yield for LT bonds which is literally the GDP growth the market expects in the LT. The inflation rate can be measured in the present. When both of these rates are low, P/E (or TMC/GDP) goes high. Low inflation means that investors can expect future prices to be much like today. Therefore they do not require a high ROI on their investments and are therefore willing to pay a higher price --- including garbage investments. Furthermore, low inflation also means that the central bank is unlikely to step in and raise interest rates to control the inflation (and eliminate garbage investments).

A further effect is that low inflation makes it easier to see whether a company is actually growing organically or just because it's following the devaluation of the currency. People are willing to pay more for real growth which again raises P/E.

In short monetary stability => high P/E. The sky is the limit in terms of how high this can really go. Therefore I'm not completely sold on the mean reversion strategy. OTOH, I'm not sold on the trending strategy that the 100%VTI religiously believe in either because at some point (like now) the Greater Fools are going to run out of Minor Fools. This is a big reason why I invest in individual stocks. This makes it possible to select for quality with TMC/GDP is high but still participate in the trend. When TMC/GDP has dropped, it's possible to do bottom fishing for greater participation in the next trend.

[Polp]

As an european investor I'm invested in european stocks with an ETFs on the Stocks Europe 600 index. I also have S&P500 and Emerging Market funds. I decided to do that based on some assumptions I am now overthinking again with more literature about the underlying theory about index investing. One of the assumptions I had when I decided my asset allocation was that GDP weighted portfolios might be better than market cap weighted portfolios. However, If you take that seriously you would have to be invested in 22% europe, 29% US, 9% Pacific and 40% emerging marketss in 2020. I definitely won't do that.

What I was wondering about just yesterday:

• What is the expected return on stocks? Do you use the equity risk premium of about 7% that was derived from the historic data from the S&P500? Or do you just use the annualized return over the longest period you can find data for? Do you have any numbers or is it just a gut feeling that it will be lower?

• I calculated the annualized performance of my assets over the last 4-5 of years because I found data for that: S&P500: 13%, Stocks Europe 600: 5%, Emerging Markets: 10%

• Do you think that european stocks will do better and US stocks worse over the next ten years? They certainly did not over the last 10, 20 or 30 years! If you look at the data you get higher risk and lower return so why would you even want that except maybe for a small percentage because they are not perfectly correlated (Correlation was about 0,7 between US and european stocks) which would reduce your risk. That is what I am wondering right now, as an european investor!

I think Warren Buffet once said that the US have the most business friendly economy of the entire world so why wouldn't US businesses do very well in the future as well?

[Tyler9000]

• What is the expected return on stocks? Do you use the equity risk premium of about 7% that was derived from the historic data from the S&P500? Or do you just use the annualized return over the longest period you can find data for? Do you have any numbers or is it just a gut feeling that it will be lower?

Rather than trying to predict the future expected returns or defaulting to an over-simplified long-term average, my personal favorite metric is what I call the "baseline return". It's the 15th percentile real CAGR for a portfolio looking at every historical start date over a given timeframe. You can read a longer explanation here: https://portfoliocharts.com/2018/11/24/ ... e-returns/

My philosophy is that if you plan conservatively while saving aggressively you're setting yourself up for long-term success no matter what happens.

[Polp]

Thank you Tyler!

By the way your website is incredible! I love it!
This comment made me think

How would you feel if you expected the advertised real return of 7.9% a year and 15 years later you look back and realize you only experienced 3.3% with your own money? I’m guessing you wouldn’t be too happy.

I also found this here by KMPG. It is just their professional "guess" of the equity risk premium by march 2019: 5,75%. However, lots of huge companies might use this number for their investment decisions.

My philosophy is that if you plan conservatively while saving aggressively you're setting yourself up for long-term success no matter what happens.

I totally agree.

[ertyu]

https://www.foreignaffairs.com/articles ... oronavirus argues that the way the us is handling the epidemic (as opposed to the uk/eu) might mean slower comparative recovery for the us. So there is an argument uk/eu economies will recover faster. Now, does that translate to stock market growth?? God only knows, esp. with the amount of QE that's coming.